What was behind today's furious buying and/or short-covering frenzy in US Treasurys, which sent the 10Y yield briefly below 2.30%, the lowest since 2017, inverted the 3M-10Y curve and pushed all bond yields left of the 30Y below the Fed Funds rate?
That was the question on every bond trader's lips today, when as stocks were tumbling, capital seemed to flood into rates. One explanation, or attempt thereof, came from BMO's Ian Lyngen, who writes that "there are certain days when the price action itself is the key development – Thursday fits this characterization." In short, the price made the price, which makes sense since there was no notable, fundamental developments to justify the third biggest percentage drop in 10Y yields in the past 12 months.
Lyngen continues, and points out one aspect of today's rates move that was not as widely discussed - the collapse in breakevens:
The outsized drop in yields given the lack of major new fundamental information more reflects a series of major technical levels being breached in short order amidst a very bond bullish backdrop. Although the move was large – third largest decline in 10-year yields YTD – several major benchmarks simply repriced toward the bottom of downward sloping channels we’ve been tracking, at least in nominal space. We’re not back in the land of the 1-handle (yes, we meant 1), at least not yet. The more interesting, and consequential, development came in breakevens and corresponded to a shift lower – running counter to policymakers’ ambitions.
The chart below shows that as of today, the market is pricing in an average inflation rate of 1.76% over the next 10 years, a sharp drop from the 1.98% on April 25.
Which is odd, considering that an increasingly greater number of strategists concede that a full blown trade war which includes tariffs on all Chinese exports, would result in sharply higher, if "transitory" inflation.
In any case, Lyngen continues, noting that "if the fall in inflation compensation continues, expect the Fed to respond in force. Unlike other central banks, they still have significant monetary policy space to employ. At this juncture, that means rate cuts, or more precisely guidance toward rate cuts. We’re skeptical that a June policy adjustment is seriously on the table outside a true collapse in inflation expectations in the next four weeks, though even a hint from Powell that easing is coming later in 2019 should serve to temporarily reassert inflation compensation toward a more comfortable level. That being said, one possible explanation of today’s price action – though not one we subscribe to – is a monetary policy error trade as the Fed is letting itself get behind the curve. To this point, the May FOMC Minutes contained no discussion of cuts, but it’s important to emphasize how stale that meeting’s context was as it occurred before the recent deterioration in talks between Washington and Beijing. Uncertainty looms large at this point, leading to our increasingly high conviction that real yields are set to move a leg lower. This repricing may end up being thematic in the lead up to the June FOMC meeting."
Follows an interesting point on today's 10-Y TIPS auction:
To that point, even in the midst of Thursday’s bullish Treasury trading that brought yields to new multi-year lows across the curve, we were encouraged to see 10-year TIPS taken down with robust underlying demand which prompted a 1 bp stop through. In past two years, this is only the second stop through we have seen at a 10-year TIPS auction (either new issue or reopening) and the fact that it was the lowest yielding since January 2018 speaks to investors’ re-evaluation of future growth forecasts.
The BMO strategist the notes that he was asked what was responsible for the aggressive bidding behavior, and offers two related explanations for the strong result.
- Firstly, with inflation compensation so low – 5-year breakevens are implying 1.3% PCE on average until 2024 – there is at least some of a “only one way to go from here” mentality. Let us not forget the trade war and what that might mean for pricing pressures and any flow through tariffs may have into CPI. This would open the possibility of TIPS outperforming their nominal cousins in coming weeks.
- Secondly, from fundamental perspective, at 57 bp over ten years, the inflation protected security surely holds an abundance of appeal give the list of things that can move real yields meaningfully higher at this stage seems to be growing shorter. Rather, a look at real rates since the end of March shows a decided move sideways and a drop to a new lower plateau as the new path of least resistance. Keep in mind that 5-year real yields were negative less than two years ago, and it’s a very live possibility that they may fall below 0 bp before the end of the year.
Another interesting point: while the rate rally occurred with strong volumes as cash traded at 131% of the 10-day moving average, there was no particular sense of panic in the move. But as Lyngen notes, this is not to say that no major asset classes are exhibiting dramatic trading behavior. Indeed, one point of recent selling has been WTI – down nearly 6% on Thursday, 13% from recent highs, and 21% YoY. Although it’s fair that prices are up YTD, this overstates the optimism surrounding global growth. Indeed, a broader look at the Bloomberg commodity index shows a modest increase of only 2% YTD, vs. a YoY drop of 14%. As BMO summarizes, "This is yet another disinflationary impulse for the Fed to contend with."
One final observation, echoing what Michael Every said earlier, is that "for all the volatility and activity Thursday in the Treasury market – its intriguing that one asset in particular was little changed, the renminbi." This is how Lyngen explains this bizarre calm in the currency which so many expect will make a run fro 7.00:
The stabilization this week contrasts sharply with the narrative of deteriorating trade negotiations which is spilling over into US rates and risk assets. This indicates a willingness for now to hold the line below the symbolic 7-handle.
The slightly more cynical take from Rabobank's Every is below:
Ladies and gentlemen, the Tech Cold War has begun. Of course, there was no reaction from CNH this morning despite China’s industrial crème-de-la-crème about to be potentially defenestrated. But, as I keep stating, that underlines the whole problem
And so, with hopes that the above makes sense in explaining today's violent move in the world's most liquidity security, Lyngen concludes that all of this happens ahead of the long weekend "as a possible bullish risk in coming weeks that would catalyze a rather sharp flight-to-quality and likely push part of the Treasury market back below 2%. "